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An Overview of Basel II – Back Testing Value at Risk

The Basel II Capital Accord, part of the wider banking regulatory accords issued by the Basel Committee on Banking Supervision (BCBS), was initially published back in June 2004 with the aim of helping to create an internationally uniform system for banking capital reserves. It has since been supported by a further accord – Basel III, which will be implemented in Europe under the Capital Requirements Directive IV.

Basel II dictates that banks must comply to new codes on banking law and control. Its main purpose, reported under the “three pillars” concept, is to encourage the advancement of risk management.

The three pillars concept covers three core areas, which were partially, but not entirely, covered by the previous Basel I regulation:

Pillar 1 – covers minimum capital requirements.

Pillar 2 – demands a supervisory evaluation of capital competence.

Pillar 3 – covers market supervision and discipline.

Steps to guarantee Basel II assurance

In order for the regulators to be assured that the pillars are being adhered to, clients must show proof of systematic VaR Back Testing, which is the recommended form to evaluate market risk set by the Basel II Accord.

Value at Risk (VaR)

VaR represents the risk basis that forecasts what an investment portfolio speculates in terms of loss over a certain amount of time.

Back Testing

The back testing system compares the anticipated losses from VaR against the actual losses achieved within a certain time period. It allows firms to identify where VaR has been miscalculated, suggesting that a portfolio has suffered more than the original VaR estimate.

The VaR predictions will be based on the results of back testing in order to then polish the templates. The templates will, in turn, become more precise, and thus lower the danger of unforeseen deficits.

Who must comply?

The Basel II Accord’s guidance applies to all banks but its observance is in accordance to each bank’s fulfilment and relative demands throughout its jurisdiction.

Five points of Back Testing Value-at-Risk

To measure the capital charge within a model calculating market risk, there are five standards to follow:

1) Every three months data sets need to be upgraded

2) Daily calculations of VaR have to be worked out.

3) For the instant price shock, a ten day movement in prices needs to be in place.

4) 99th percentile, one-tailed confidence is to be applied.

5) For “historical” monitoring to occur, a minimum term of one year should be observed.